The Search for Clarity: Multifamily and Commercial Real Estate Investing in 2023

For the last fifteen years, multifamily and commercial real estate investors surfed a rising wave of increasing property valuations buoyed by abundant and cheap capital. But in 2022 the ebb currents gained the upper hand and liquidity washed away. The culprit? The return to higher interest rates powered by the Fed’s wrestling match with inflation. There was no moment when the music stopped for CRE investing, as there was in 2007 when spreads on AAA CMBS bonds suddenly blew out by 1500 basis points. Instead, since the spring of last year there has been a gradual return to the old-world reality of market-based interest rates. While interest rates today are not that high historically speaking, the doubling of rates in a year has wreaked havoc on owners of multifamily and commercial properties across markets and property types. The on-going volatility is so consequential and long-lasting that the motto for the industry may have to be changed to “location, location, the Fed.”

If it comes as any consolation, the current threat to property values and yields was not the industry’s doing but rather the result of shifts in the economy and the capital markets. Supply and demand are relatively in balance and most property sectors have been generating generous returns for their investors. But as rental growth slows from the almost absurd rates seen in the last few years, and inflation pushes up wages and other operating costs, property cash flows are likely to be squeezed. In combination with a higher cost of capital, that means falling asset values. Some reports are saying we are not in a downturn but a return to normal conditions. That’s wrong and right. We are returning to historically normal conditions in terms of higher rates and improved wage inflation, but this new reality will cause values to fall and, having been through quite a few, I call that a downturn in the cycle.

The transition from a policy-induced boom market to a market-based real estate investment environment will be rough for a lot of owners. Even if the Fed backs down later this year or in 2024, higher interest rates are here to stay. The biggest deterrent to capital flows is uncertainty, and not knowing where rates will land will keep liquidity on the sidelines and prolong the process of price discovery. The search for clarity won’t be solved in a few months, it will take time for sellers to capitulate to new pricing and for lenders to believe in the new valuations. We may not understand the full extent of sector distress until we move through hundreds of billions of dollars of loan maturities in the next several years. But real estate companies and banks are healthy, property fundamentals remain relatively strong, and, like so many times before, the industry will adjust to the new market conditions and capital will flow once more.

The Context – Demand Drivers and Economic Volatility

Several key ingredients are needed for the real estate market to thrive: population growth, high employment and good wages, and people willing to spend money on goods, services, and leisure.

Demographics: Where did all the people go?  The long-term health of any economy requires population growth. In fact, many countries around the world face the prospects of shrinking populations and the economic woes that follow. In the United States, we are around break-even with the population growing very slowly in recent years, around 0.5% growth in 2022. Americans are not having children at the rates needed to organically grow the population, and immigration has slowed dramatically over the last few years due to both policy changes and the pandemic.

A lot was written during the pandemic about population migration around the country that is fueling growth in some markets at the expense of others. These migration patterns have been ongoing for decades but certainly accelerated recently, helping markets in the Sun Belt and western and mountain states. But a key driver of these moves is a lower cost of living, and the influx of people in some markets has altered that calculus, particularly housing costs. Metropolitan areas with the greatest in-migration have gotten so expensive that they are no longer affordable to many families. In addition to spectacular rent growth, Phoenix, Atlanta, and Miami had the highest inflation rates of the metro areas, according to Yardi Matrix. While these communities remain attractive, we expect migration patterns to shift in the next few years and investors will need to monitor these trends in local demand. Demand is already rising in midwestern and northeastern cities (see more on the multifamily sector below). The winner for in-migration and rent growth in 2022 was not Austin but Indianapolis.

Another area to highlight demographically is the aging of America’s Baby Boomers.  According to the Pew Research Center, about 10,000 Boomers have been turning 65 each day since 2010, and their average age is now about 66. Over the next few years all 70+ million Boomers will be of retirement age, and some will be in their 80s. The group is already draining the labor force and will be consuming less while requiring more health care services. This is a demographic dynamic of unprecedented proportions for the real estate industry that will bring extraordinary opportunities for those who respond to changing demand for new products and designs accommodating the changing needs of this aging generation.

Employment: Real estate’s greatest tailwind A strong job market is the single most important driver of real estate demand and despite all the economic turmoil the employment remains on fire. The economy gained a whopping 4.5 million jobs in 2022, pushing down the unemployment rate to 3.5% at the end of the year. In January an additional 517,000 jobs were added, almost three times the market’s estimate, bringing down unemployment to 3.4%. The ratio of open positions to unemployed workers has risen to 1.9x. Technology companies may be laying off tens of thousands, but small businesses remain desperate for talent. A recent Barron’s survey indicated that 93% of business owners seeking to hire in December had few or no qualifying applicants. The shortage of workers has been caused by many factors including the lack of immigration, the on-going and increasing rate of Boomer retirements, and a surprising number of Gen Z staying out of the work force, particularly less educated younger men. Making matters worse is the lack of mobility of the American workforce due to high housing costs and mortgage rates – many people won’t give up their current low mortgage rate and move to a new job opportunity when mortgage rates have doubled.  

Consumption: The economy’s fuel American consumers are still spending, just a little bit less. They have jobs with higher salaries and about half of the pandemic stimulus checks are still in their bank accounts. Credit card balances, at $930 billion at the end of the third quarter of 2022, have returned to their pre-pandemic high after falling $150 billion during the lockdown. No doubt inflation has taken a bite out of the spending budget, especially due to volatile gas prices and groceries rising at an astonishing 11%. Inflation, the threat of a recession, and job cuts in the headlines are understandably making people nervous. The University of Michigan Consumer Sentiment Index is down to 59 from 96 just before the pandemic. And a McKinsey study indicated a significant drop in the American optimism for the economy last year that cut across income, gender, and age groups. Nonetheless, spending dropped by a mere 0.1% and 0.2% in November and December, respectively. A continued willingness to spend is critical for economic growth (it accounts for about 70% of GDP) and the health of retail, restaurant, and hospitality sectors of real estate (see more on the retail sector below).

Inflation: The root problem Now that the topic of inflation has been broached, what began as a pandemic-induced trend seems to want to hang around, despite all efforts of the Fed. And the main ongoing driver is wage gains (about 4.8% in 2022), which of course is good news for American workers but not so great for policy makers. Other long-term inflation drivers include de-coupling from China and de-globalization generally, growth in spending power and demand from major emerging economies such as India, the continuing uncertainty over global fuel costs due to geopolitical turmoil, and the reduction in the Fed’s balance sheet. But it does appear the worst may be over, with inflation rates rapidly dropping in the last six months of 2022. The Personal Consumption Expense (PCE) index (the Fed’s reported favorite measure of inflation) rose just 0.1% in November and December 2022, resulting in a year-over-year inflation rate of 5% in December (4.4% excluding food and energy). Annualizing the December month-over-month rate yields a PCE measured inflation of just 1.2%.

Despite the good news, property owners are feeling the impact of rising operating costs. Higher wages and insurance costs are long-term shifts, while utilities and building materials and supplies remain volatile. These higher expenses are shrinking property cash flows and increasing the need to raise rents, which is becoming increasingly difficult in many markets.

Interest Rates: Real estate is the collateral damage in the war against inflation We don’t need to reiterate here how significantly interest rates rose in 2022. And rates will likely keep rising for much of 2023. That means investors must pay more to get the same, even as values fall. Without free money, the price of all classes of assets must reset. Only a wave of new liquidity can prevent capitalization rates from widening, and with the direction and longevity of higher rates so uncertain that does not appear to be happening.

The markets are predicting that rates will begin to decline this year, but the Fed’s dot plot suggests otherwise – the Fed Funds rate reaching 5.1% at the end of the year. It seems strange that the market thinks it knows better than the folks who actually set the rates. Relief is likely not short-term and all players in commercial real estate will have to adjust to the new reality. As mentioned, that adjustment will be painful for some, particularly those with floating rate loans that were not properly hedged. Uncertainty over the direction of rates has lifted the price of interest rate caps to over ten times what they were a year ago.

Recession: The threat to recovery The range of projections of whether and when we will enter an economic recession is extraordinary. Culling through the noise, the consensus seems to suggest a recession later this year that will be relatively benign. Afterall, the job market is amazing and GDP growth has been remarkably resilient at an almost 3% annualized rate in the fourth quarter of 2022. However, talk of recession typically gets businesses and individuals nervous and that reduces demand for space. If we have a more significant economic recession, the real estate industry will have to deal with falling demand, slower leasing, and falling rents on top of coping with a higher cost of capital. Any further reduction in demand could be the straw that breaks the camel’s back for the office sector, already suffering from tenants wanting to shrink their footprint. The hotel business, which has thrived during the past year, could be hampered by a pullback in leisure travel once the “R” word is uttered by the powers that be.

The Impact – An Unpredictable Investment Environment

In only one year, the formerly robust multifamily and commercial real estate sectors became entangled in a web of demographic, geopolitical, and economic dynamics that are interconnected and complex, creating an atmosphere of uncertainty and risk, threatening investment yields and property values, and constraining liquidity and transactions. The longer the uncertainty, the greater the likelihood of distress. Here are several themes to watch for as the industry seeks clarity amidst the uncertainty:

Value add or value subtract? Values have been propped up by artificially low interest rates for over a decade. Investors – active and passive – have piled into value-add real estate deals hoping to ride the upswing in rental rates and take home a quick and rich return. Did these investors really think the party could last forever? The one thing every real estate investor should know, but tries to forget, is the cyclicality of real estate values. Now that the cost of capital is approaching longer-term normalcy, valuations must fall. The Green Street Commercial Property Price Index declined 13% in 2022, with retail having the sharpest drop of 21% and multifamily taking second place at 19% (that’s right, multifamily). How much further prices will fall is anyone’s guess: It will depend on the market, asset class, tenancy, and capital structure of each asset, and the future direction of mortgage rates. But that uncertainty is freaking out owners who in every downturn are slow to accept the inevitable, and lenders who manage risk by having an adequate equity cushion to prevent losses. Price discovery will likely take another 12-to-18 months.

Interest rates are not the only threat to value. Property net operating income is shrinking due to higher operating costs. And the greatest buffer against widening capitalization rates – liquidity – is waiting to see how the dust settles before jumping back into the game. Until then, there are fewer transactions, and the lack of transactions prevents price discovery, and debt capital becomes even more scare…a vicious cycle. Only more predictable capitalization rates and exit values, and seller capitulation, will bring stability to the sector.

Liquidity, liquidity everywhere but not a drop to drink For years we’ve described the hundreds of billions of dollars of dry powder held by real estate investors. With the exception of distressed investors, those funds remain super dry. With valuations so unpredictable, equity capital is nervous. Some want to pull out, as suggested by the headlines about private REITs hitting their withdrawal limits. According to IDR Investment Management, $20 billion was withdrawn from core property funds during the fourth quarter. The Hodes Weill 2022 Allocations Monitor noted that the runup in real estate prices until last year has resulted in some institutional investors being overallocated to real estate. The report also notes a significant pullback in international investors in U.S. real estate. The CBRE 2023 U.S. Investor Intentions Survey found that almost 60% of respondents expect to lower their commercial real estate investments in 2023 vs. just 15% who expect to invest more. The report also demonstrated the unwillingness to sell into this market, with 60% saying they will either sell less than in 2022 or not at all. The equity pull back amid value and rate uncertainty resulted in fourth quarter transaction volume dropping 62%, according to RCA. That trend is likely to continue without more clarity on market dynamics.

Debt capital has also pulled back, particularly due to collateral value uncertainty, as mentioned above. Lending continues but at a much slower pace, except for Fannie Mae and Freddie Mac multifamily deals. Banks, insurance companies, mortgage REITs and debt funds are all finding it difficult to underwrite and, for non-balance sheet lenders, fund their lending platforms. Issuance of commercial mortgage back securities (CMBS) and collateralized loan obligations (CLO) fell almost 40% in 2022 as it became more and more difficult to underwrite and price deals for both the lenders and the bond buyers. Banks are dealing with more and more regulation, not the least of which is the new CECL (Current Expected Credit Loss) accounting rule that requires lenders to project losses on loans when they are originated. How do you accurately project losses on a new loan underwritten to have none?

The new math of higher interest rates Real estate may be made of bricks and mortar but for most investors the focus is on yields. A higher cost of capital translates to lower yields on existing and future investments, making real estate less attractive as an alternative asset class. The math is simple: The lender gets more of the property’s cash flow and the investors less. And as higher cap rates push down valuations the exit is likely not as rich as initially expected. For the sponsors of real estate investment ventures, including private equity funds, the reduction in cash flow could diminish or even wipe out promotes. When that happens the interests of the sponsor and the investors may no longer be aligned.

About a third of commercial mortgages have floating rates, including the financing on most of the value-add transitional strategies. In the unlucky event the rates on those loans were not hedged, the investor’s mortgage payments have doubled and buying a cap rate contract may no longer be viable as the cost could wipe out a portion of the remaining distributions on the deal. On a $25 million mortgage a cap contract that once cost $50,000 may now cost over $600,000.

Cash out is now cash in Rising values over the last decade allowed property owners to refinance their loans at higher and higher amounts of debt, each time putting the difference between the new mortgage and the old mortgage in their pockets. That return of capital to investors has been a key strategy in real estate investing. But with values falling and lenders being appropriately conservative, proceeds on new loans are likely below the current loan, meaning the borrower needs to write a check to refinance.

Trepp reports that $450 billion of multifamily and commercial mortgages will mature in 2023 and $490 billion in 2024. A lot of equity capital will be required if many of those refinancings need topping up to lower the loan-to-value ratio or better cover higher debt service. The lender may agree to an extension, but it’s unlikely the borrower could avoid paying down a portion of the loan to win their approval. And loan forbearance is a thing of the past – time is money in a higher interest rate environment. The upshot is that investors that had been enjoying distributions will now have to give some of that money back. And investors facing multiple loan maturities could ultimately run out of cash. It is tough to predict the tipping point when a little pain turns into real distress. There are plenty of capital sources waiting to provide the extra cash to distressed borrowers, especially when the properties have solid performance. But those funds are awfully expensive. Obviously, no one will be refinancing their debt in 2023 unless they absolutely have to.

Multifamily: Is the bloom off the rose? Yardi reported that national multifamily rent growth fell from 13.5% in 2021 to 6.2% in 2022, and is expected to be 3.1% in 2023 and 4.1% in 2024. Walker & Dunlop estimates rental growth of 4.5% in 2023 and 2% in 2024. According to Apartment List, national rents fell 0.3% in January. The trend is clear: Record rent growth during the pandemic contributed to the nation’s housing affordability crisis and was unsustainable. Projected growth represents a return to the historical norm of 2.5% to 3.0% in most markets. As mentioned earlier, the rapid rise in rents in several Sun Belt and western markets has eroded the affordability factor that made them so attractive, and demand for cheaper housing in Midwest cities is taking hold. Apartment List reported that fastest growing rents last year were in Indianapolis, Kansas City, Columbus, Chicago, Cincinnati, and St. Louis.

Rents are also under pressure from new supply of units, which tend to be bunched in those Sun Belt markets. Occupancy is also falling a bit, from 97% in 2021 to about 95% at year-end, according to Berkadia. For investors, the return to normal rent growth and vacancy will be disappointing, but the country desperately needs more affordable housing. The concern now is that recently robust development of apartments is slowing as economics deteriorate. The federal and local governments are lining up to address the housing issues, and hopefully will focus first on supporting development to increase supply.

Rose bushes always have new buds to replace the old flowers. The run up in multifamily may be slowing but the fundamentals remain strong. An increasing number of Gen Z are in their peak renting years, and high residential mortgage rates are preventing Millennials from transitioning from renting to home ownership. Unfortunately, lack of affordability is slowing household formation and reducing demand. Still, the sector should remain healthy for the next few years if not quite as robustly as during the past five.

Long Covid: The office market The real estate industry is by nature optimistic and predicted the office market would quickly turn around after the pandemic. But most now acknowledge that the sector has a long-term problem and is starting to look like malls did a decade ago. No doubt more people are going back to work, but not all the time and not at the same time. The continued transition to a hybrid workforce and a smaller required footprint is restricting leasing, putting pressure on rents, and adding to the inventory of sub-let availability. This story will evolve over years, as leases expire and mortgages mature. But what is clear today is that there will be winners and losers, with the newer, better designed, environmentally friendly, and amenity-filled buildings in the first category. What happens to the rest may take a decade to discover, just as in the overstored retail market. That is, unless more owners follow the footsteps of RXR, the major New York City office owner, which recently announced its intention to give its older, obsolete buildings back to the bank. While there is much talk about conversions to multifamily housing, Trepp reported that just 13.4 million square feet were converted 2022 with projections of 42.6 million square feet between 2023 and 2025. That’s less than 1% of the overall office stock and will hardly solve the problem.

According to Newmark, Manhattan had 1.6 million square feet of negative absorption in 2022 after a 40% drop in leasing. Savills reported that San Francisco’s office availability rate had reached 30% by the end of the year, far higher than the national average of about 18%. Tenants in most markets are demanding less space, shorter leases, with quality fit outs, and it’s hard to make those leases economical. Lower net effective rents and shorter leases translate to lower valuations, making refinancings particularly difficult. Trepp reported that loans on 583 office properties will mature in 2023 and 2024, more than half of which have floating rates. Expect more distressed situations and more loans in special servicing.

Retail: From dodo to phoenix Office appears to have replaced retail as the industry’s problem child. There was good news almost everywhere in the retail sector in 2022, bolstered by more healthy retailers who are finally opening more stores than they are closing, and shoppers eager for the in-store shopping experience. Neighborhood centers continued to outperform. According to Cushman & Wakefield, shopping centers have their lowest vacancy since 2007, falling from 8% in 2021 to 5.7% by year-end 2022. This is translating to rent growth. In an extraordinary turn of events after years of retail distress, new development is increasing. We still have too much retail, but it varies from market to market, and the B class malls are under threat of extinction as an asset class. Online shopping isn’t going away and a recession could put a dent in consumer spending. But the positive news proves once and for all the cyclicality of real estate investing.

New deals, new rules Despite all the chaos in the real estate sector deals continue to get done, but there are new rules. Investors looking to deploy capital must be more diligent in their diligence and expect every part of the transaction process to take longer. The dozens of assumptions analysts are used to dropping into their cash flow models must be re-evaluated, whether rental growth, expense growth, or the exit cap rate. Financing is available in targeted markets and for better performing property types, but at lower loan-to-value and higher coverage and debt yield ratios. Borrowers should even expect to pay back a little principal each month as lenders have more appreciation for the benefits of amortization. And unless cap rates rise, a daunting prospect for property owners, higher interest rates continue to create negative leverage for most deals. Negative leverage is cured by adding value through rental growth, and as mentioned rental growth is slowing and transitional loans are uber expensive. There are always opportunities to make money if investors pick their spots and realize that success will come from laser-focused property operations and not financial engineering. But it’s time to hunt for singles and doubles rather than count on home runs.

2023: Pausing in a volatile marketplace For owner operators and investors, 2023 will likely be a year to clean house rather than build portfolios. The focus will be on managing revenue and operating costs, perhaps on a more granular level that was required in the past. Investors in value-add and opportunistic deals will need to reassess their ability to execute the business plan, and update their models for new operating and cap rate assumptions consistent with current trends in the market. To dig into the numbers, management needs enhanced data and reporting to more closely monitor project and portfolio performance and quickly make decisions – to take advantage of opportunities or mitigate oncoming risks. This is particularly important for passive investors who do not typically receive detailed reports from the transaction sponsors and may not even know whether they have adequate hedges against floating rate mortgages or when they mature. For investors counting on a certain level of distributions, additional financial planning may be in order.

Unlike the Great Financial Crisis, today’s woes rest with providers of equity capital – the property owner/investor – and not the lenders. Values may fall but lenders are likely well-protected by solid underwriting. The burden will fall to the equity investors to have the capital to fund property improvements and refinancings, and many will need to raise fresh funds to meet those needs. Retaining operating cash flow rather than making distributions to equity partners will be a difficult choice, but an essential strategy to meet on-going cash needs.

We are not in a crisis, but the industry is in the middle of a long, slow bleed. The triple threat of higher interest rates, inflation, and the possibility of recession will influence decision making and capital flows in the year ahead. As the markets reset, so must the mindset of all players in multifamily and commercial real estate investing. We are reverting toward historical norms – higher capital costs, slower rent growth – and the government will likely no longer be there to support asset values. At some point, hopefully later this year, the uncertainty will ease, and equity and debt providers will have sufficient clarity to deploy capital. Once again, as in every cycle, liquidity will flow to multifamily and commercial real estate.